Cash is a bear (market) necessity

Jeremy Grantham, the money manager who oversees $157 billion as chairman of Grantham, Mayo, Van Otterloo & Co. L.L.C., said investors should shun stocks and hold cash during the worst financial crisis in more than 60 years.

"Don't be a hero," Grantham, 69, said last week in an interview from his office in Boston. "Move to cash and let the other guys fish around for the bargains in the wreckage."

Dubbed a "perma-bear" for his dour view on U.S. equities for more than a decade, Grantham correctly predicted a crash in technology stocks two months before the bubble burst in March 2000. Grantham told his firm's investors that if they want to take the risk of investing in stocks, they should stick with the "highest-quality" large U.S. and emerging-market shares.

The $2.2 billion GMO U.S. Quality Equity Fund III, which gained 6 percent last year, was down 4.7 percent for the last three months, a period that has seen the S&P 500 index down 11.7 percent, and the Russell 2000 index down 14.3 percent.

Grantham said investors should hedge stock positions by selling short the Russell 2000 index, which tracks the smallest U.S. companies. In successful short sales, investors sell shares they have borrowed and buy them back at a lower price, pocketing the difference.

"This is the most important U.S. financial crisis since World War II," he said.

A surge in defaults of loans made to the riskiest borrowers has sparked a worldwide credit crisis, leading to $133 billion in write-downs by banks and investors balking at all but the safest debt securities.

Grantham said the financial crisis was likely to push the U.S. economy into a recession. Conditions are worse than the savings-and-loan crisis of the 1980s, when the failure of thrifts cost U.S. taxpayers more than $160 billion, he said.

"The S&L crisis was parochial in comparison," Grantham said. "This is the first one that is global; it has tentacles everywhere."

Billionaire investor George Soros said last week that a U.S. recession was all but certain, but that the global economy would probably avoid a contraction.

Grantham said he expected stocks to reach a bottom in 2010.

"There are plenty of bad things left in this cycle," he said.

The fund manager has been predicting a weak U.S. equity market since 2006. The Standard & Poor's 500 index returned 16 percent in 2006 and 5.5 percent in 2007.

Stock and bond funds managed by Grantham's firm returned 19 percent on an asset-weighted basis in the three years ended Nov. 30, double that of the S&P 500, according to data tracked by Morningstar Inc., of Chicago. The funds advanced 15 percent in the first 11 months of 2007, compared with the 6.2 percent gain in the S&P 500 during that period.

Grantham, who helped start Grantham, Mayo, Van Otterloo in 1977, said credit problems were likely to spread beyond subprime mortgages to commercial real estate loans and debt used to finance private-equity transactions.

"Private-equity deals will be in trouble," Grantham said. "They were under-researched and over-leveraged, and we had reached a level where the junkiest possible companies were selling at high prices."

Grantham, who last week published a quarterly letter to investors, wrote that private equity "is the most underappreciated risk of all and is likely to be the center of another phase in the crisis."

The cost of bonds and loans used to pay for buyouts has doubled since June, according to Merrill Lynch & Co. Inc. data. That will limit the fees and profits that leveraged-buyout firms generate from buying and selling companies.

Cerberus Capital Management L.P. Chairman John Snow and the Carlyle Group cofounder David Rubenstein were among the executives at the World Economic Forum at Davos, Switzerland, saying that lack of credit is hobbling the pace of leveraged buyouts.

Snow said banks needed to "purge" about $200 billion in loans that have not found buyers before LBOs can resume. Rubenstein said the pace of takeovers of large companies would slow in 2008 because of a lack of debt investors.

Manager:

Sam Wilderman.

Assets:

$2.24 billion.

Performance:

Down 5.5 percent in 2008; up 6.0 percent in 2007.

Key holdings:

Pfizer Inc., Johnson & Johnson, Merck & Co. Inc., Microsoft Corp., Wal-Mart Stores Inc.

Ticker:

GQETX

SOURCE: Bloomberg News, Morningstar Inc.